SECURITY ANALYSIS AND PORTFOLIO

MANAGEMENT

Take calculated risks. That is

quite different from being
rash.

03/19/10 BY: PROF. [Link] 1

 SECURITY

 Investments in capital markets are in various financial

instruments.

 These instruments may be of various category with different

characteristics.

 These are called securities in the market parlance.

 It includes shares,bonds,debentures or any marketable securities

of a like nature of any company,[Link] or semi-
[Link].

03/19/10 BY: PROF. [Link] 2

 SECURITY ANALYSIS

 Security analysis in both traditional sense and modern sense

involves the projection of future dividend, or earnings flows,forcast
of the share price in the future and estimating the intrinsic value of a
security based on the forecast of earnings or dividends.
 In addition to above, the modern approach includes risk and return
analysis for the securities.

 Basically securities analysis contains the analysis of:

 The trend and scenario of the economy.

 The trend and scenario of the industry to which company belongs.
 The strength and weakness of company itself viz. promoters and
management track record, financial results, projections of
expansion,diversification,tax planning etc.

03/19/10 BY: PROF. [Link] 3

 PORTFOLIO

 A combination of such securities with different risk-return

characteristics will constitute the portfolio of the investors.

 Thus ,a portfolio is a combination of various assets and/or

instruments of investments.

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 PORTFOLIO MANAGEMENT

 Portfolio analysis includes portfolio construction, selection of

securities, revision of portfolio, evaluation and monitoring of the
performance of the portfolio.

 All these are part of the subject of portfolio management which is

a dynamic concept ,subject to daily and hourly changes based on
the information flows and a host of economic and non-economic
forces operating in the country on the markets and securities.

03/19/10 BY: PROF. [Link] 5

 INVESTMENT

 Investment is parting with one’s fund, to be used by another

party, user of fund, for productive activity.

 It can mean giving an advance or loan or contributing to the

equity(ownership capital) or debt capital of a corporate or non-
corporate business entity.

 In other words, investing means building up to meet future

consumption demand with the intention of making surpluses or
profits, as they are popularly known.

03/19/10 BY: PROF. [Link] 6

 INVESTMENT ACTIVITY
(ACQUISITION OF ASSETS)
1. FINANCIAL ASSETS 2. PHYSICAL ASSETS
CASH HOUSE
SAVER LAND
BUILDINGS
FLATS
BANK DEPOSITS
INVESTOR GOLD
P.F./LIC SILVER
OTHER METALS
PENSION 3. MARKETABLE
ASSETS
POST OFFICE
CERTIFICATES SHARES, BONDS, CONSUMER
& GOVT. SECURITIES, DURABLES
DEPOSITS M.F. SCHEMES, UTI

NEW STOCK
MARKET
ISSUE

03/19/10 BY: PROF. [Link] 7

 RISK-RETURN RELATIONSHIP

 RISK : Risk is inherent in any investment. This risk may relate to

loss or delay in repayment of the principal capital or loss or non-
payment of interest or variability of returns. While some
investments are almost risk less like [Link] or bank
deposits, others are more risky.

 RETURN: Return differs amongst different instruments. The most

important factor influencing return is risk. Normally, the higher
the risk ,the higher is the return. See the figure in the next
slide……..

03/19/10 BY: PROF. [Link] 8

 RISK RETURN RELATIONSHIP

Venture fund(highest risk)

Equity shares

convertible debentures / MFs

Non-convertible debentures
RETURN

PSU BONDS

Lowest Risk (Bank

deposits)

RISK

03/19/10 BY: PROF. [Link] 9

 INVESTMENT VS SPECULATION

 It is for a longer time horizon.  It is for a short period of time.

 It requires higher risk.
 It requires moderate risk.
 It’s objective is to get high
 It’s objective is to get a returns along with higher risk.
moderate return with a
limited risk.  It considers inside
 It considers fundamental information, hearsays and
factors and evaluate the market behavior.
performance of the company
regularly.  Speculator uses borrowed
 Investor uses his own funds funds to supplement his
and avoid borrowed funds. personal resources.

03/19/10 BY: PROF. [Link] 10

 THE INVESTMENT PROCESS

 Determine the investment objectives and policies

 Undertake security analysis
 Construct a portfolio
 Review the portfolio
 Evaluate the performance of the portfolios

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 TYPES OF INVESTORS

 The contrarians

 Trend followers and

 Hedgers and holders

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 THE INVESTMENT ENVIRONMENT

 FINANCIAL INSTRUMENTS

 FINANCIAL INTERMEDIARIES

 FINANCIAL MARKETS

03/19/10 BY: PROF. [Link] 13

 ASSIGNMENT FOR DISCUSSIONS- 1

DIFFERENT KIND OF SECURITIES:

FOR EXAMPLE:

 EQUITY SHARES
 SWEAT EQUITY
 NON-VOTING SHARES
 RIGHT SHARES
 BONUS SHARES
 CUMULATIVE PREFERENCE SHARES
 DEBENTURES
 BONDS
 ZERO COUPON BONDS
 DEEP DISCOUNT BONDS…….ETC….

03/19/10 BY: PROF. [Link] 14

 CASELETS-1: Small Cement Company (SCC) , Efficient
Cement Company (ECC) and Big Cement Company (BCC)

EVENT PROBABILITY RETURNS

(effect on price) SCC ECC BCC

5% decline 20% -5% 0% 5%

Flat 30% 10% 10% 10%

5% increase 40% 25% 20% 15%

10% increase 10% 35% 30% 25%

MAKE AN INVESTMENT CHOICE WITH JUST THESE DETAILS.

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 EXPECTED RETURNS

SCC : 20%* -5% + 30%* 10% + 40%* 25% +

10%* 35% = 15.5%

ECC : 14%

BCC : 12.5%

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 CASELETS – 2 & 3

(2) You have invested Rs. 50,000/- , 30% of which

is invested in Company– A, which has an
expected rate of return of 15%, and 70% of
which is invested in Company- B, with an
expected return of 12%. What is the return on
your portfolio? What is the expected percentage
rate of return?
(3) The current market price of a share is Rs.300/-
An investor buys 100 shares. After one year he
sells these shares at a price of Rs.360/- and also
receives the dividend of Rs.15/- per share. Find
out his total return, % return, dividend yield and
capital gains and capital gains yield.
03/19/10 BY: PROF. [Link] 17
 SOLUTION - 2

Return on portfolio:
Company A : .30 x Rs.50,000 x .15 = Rs.2,250
Company B : .70 x Rs.50,000 x .12 = Rs.4,200

TOTAL RETURN : 2,250 + 4,200 = Rs.6,450

Expected percentage rate of return:

6,450/ 50,000 x 100 = 12.9%

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 SOLUTION-3

Initial Investment = 300 x 100 = Rs.30,000

Dividend earned = 15 x 100 = Rs. 1,500
Capital gains = ( 360 – 300 ) x 100 = Rs.6,000
Total Return = 1,500+ 6,000 = 7,500
Total percent Return = 7,500/30,000 x 100
= 25%
Dividend Yield = 15/300 x 100 = 5%
Capital Gains yield = 6,000/30,000 x 100
= 20%

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 CASELETS - 4

Shares A and B have the following probability

Distribution of possible future returns:
Probability(pi) A (%) B (%)
0.1 -15 -20
0.2 0 10
0.4 5 20
0.2 10 30
0.1 25 50
(a) Calculate the expected rate of return for each share and
standard deviation of return for each share
(b) Calculate the coefficient of variation

(c) Which share is less risky. Explain.

03/19/10 BY: PROF. [Link] 20

 SOLUTION- 4

FOR SHARE A:
r% pi ripi% (r – r¯)% (r-r¯)2 (r-r¯)2pi(%)
-15 0.1-1.5 -20 400 40
0 0.2 0 -5 25 5
5 0.4 2 0 0 0
10 0.2 2 5 25 5
25 0.1 2.5 20 200 40
r¯ = 5 σ2 =90
Since σ2 = 90 , σ = √90 = 9.5%

03/19/10 BY: PROF. [Link] 21

 SOLUTION – 4

Similarly for share – B:

Expected rate of return = 19% and S.D. = 17%

(b) Coefficient of variation = σ / r

For share A = 9.5% / 5% = 1.9
For share B = 17% / 19% = 0.89

( C) Share B is less risky than share A. Since coefficient of

variation ( a measure of relative risk) is smaller for Share
B.

03/19/10 BY: PROF. [Link] 22

 RISK RETURN PROFILE OF TWO ASSET
PORTFOLIO
Portfolio return, Rp = w1R1 + w2R2
Portfolio risk, σ2p = w21 σ21 + w22 σ22 +
2 w1w2 Cov(R1R2)
Here, Cov(R1R2) = ρ σ1 σ2
And, w1+ w2 = 1
Or, we can write ,
σ2p = w21 σ21 + w22 σ22 + 2 w1w2 ρ σ1 σ2
now, we will examine two special cases of perfect
positive correlation and perfect negative correlation
which is very significant in portfolio theory.

03/19/10 BY: PROF. [Link] 23

 RISK RETURN PROFILE OF TWO ASSET
PORTFOLIO

FIRM 1 FIRM 2
Return 15% 30%
S.D. 10% 20%
With perfect positive correlation ( ρ = +1)
Portfolio return, Rp = w1R1 + w2R2
Portfolio risk, σ2p = w21 σ21 + w22 σ22 + 2 w1w2 σ1 σ2
= (w1 σ1 + w2 σ2)2
or, σp = w1 σ1 + w2 σ2

03/19/10 BY: PROF. [Link] 24

 PORTFOLIO RETURN AND RISK WITH C.C. = 1

ALL FIGURES IN %
W1 100 80 60 50 40 20 0

W2 0 20 40 50 60 80 100

Rp 15 18 21 22.5 24 27 30

σp 10 12 14 15 16 18 20

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 PORTFOLIO RETURN AND RISK WITH C.C. = - 1

Portfolio return, Rp = w1R1 + w2R2

Portfolio risk, σ2p = w21 σ21 + w22 σ22 - 2 w1w2 σ1 σ2
= (w1 σ1 - w2 σ2)2
or, σp = w1 σ1 - w2 σ2
ALL FIGURES IN %
W1 100 80 60 50 40 20 0
W2 0 20 40 50 60 80 100
Rp 15 18 21 22.5 24 27 30
σp 10 4 2 5 8 14 20

03/19/10 BY: PROF. [Link] 26

 KEY INDICATORS IN INDUSTRY ANALYSIS

The analysts is free to choose his or her own indicators for analyzing the
prospect of an Industry. However , many commonly adopt the following
indicators.
(A) Performance factors like:

 Past sales at least for three years

 Future sales for at least two years
 Past earnings at least for three years
 Future earnings for at least two years

(B) Environment factors like:

 Attitude of government
 Lab our conditions
 Competitive conditions
 Technological progress

(C ) SWOT analysis

03/19/10 BY: PROF. [Link] 27

 SOME RELEVANT QUESTIONS FOR INDUSTRY
ANALYSIS

 Are the sales of industry growing in relation to the growth in Gross

National product ( GNP) ?
 What is overall return on investment (ROI) ?
 What is the cost structure of the industry ?
 Is the industry in a stable position ? Does the success or failure
depend upon any single critical factor ?
 What is the impact of taxation upon the industry ?
 Are there any statutory controls in matters of raw materials
prices, distribution etc ?
 What is the industrial relations scenario of the industry ?
 Is the industry highly competitive ? Is it dominated by one or two
major companies ? Are they Indian or foreign ? Is there sufficient
export potential ?Are international prices comparable to domestic
prices ?

03/19/10 BY: PROF. [Link] 28

 ASSIGNMENT FOR DISCUSSION- 2

NEW ISSUE MARKET OR PRIMARY MARKET AND ITS

FUNCTIONS
PARTIES INVOLVED:
 Manager to the issue

 Registrar to the issue

 Underwriters

 Bankers to the issue

 Government and statutory agencies etc….

PLACEMENT TO THE ISSUE

 Offer through prospectus

 Bought out deals

 Private placement

 Right issue

 Book building etc

03/19/10 BY: PROF. [Link] 29

 ASSIGNMENT FOR DISCUSSION- 2

 GREEN SHOE OPTION

 RED HERRING PROSPECTUS
 E-IPO
 QUALIFIED INSTITUTIONAL BUYERS (QIBs)
 STOCKINVEST
 FUNCTIONS AND POWER OF SEBI
 SECONDARY MARKET
 PRIMARY VS. SECONDARY MARKET
 FUNCTIONS OF SECONDARY MARKET
 PRINCIPAL WEAKNESSES OF INDIAN STOCK MARKET

03/19/10 BY: PROF. [Link] 30

 PORTFOLIO SELECTION THROUGH MARKOWITZ
MODEL

 The objective of every rational investor is to maximize his returns

and minimize the risk .
 Diversification is the method adopted for reducing risk.
 It essentially results in the construction of portfolios.
 The proper goal of portfolio construction would be to generate a
portfolio that provides the highest return and the lowest risk.
 Such a portfolio would be known as the optimal portfolio or
efficient portfolio.
 The process of finding the optimal portfolio is described as
portfolio selection
 The conceptual framework and analytical tools for determining the
optimal portfolio in disciplined and objective manner have been
provided by Harry Markowitz.
 His method of portfolio selection has come to known as the
MAROWITZ MODEL.
 In fact MM is the base of modern portfolio theory.
03/19/10 BY: PROF. [Link] 31
 FEASIBLE SET OF PORTFOLIOS

 With a limited number of securities an investor can create a very

large number of portfolios by combining these securities in
different proportions.
 This is also known as the portfolio opportunity set .
 Each portfolio in the opportunity set is characterized by an
expected return and a measure of risk ,viz.,variance or standard
deviation of returns.
 Not every portfolio in the opportunity set is of interest to an
investor.
 In the opportunity set some portfolios will obviously be dominated
by others.
 A portfolio will dominate another if it has either a lower standard
deviation and the same expected return as the other, or a higher
expected return and the same standard deviation as the other.
 Portfolios that are dominated by other portfolios are known as
inefficient portfolios.

03/19/10 BY: PROF. [Link] 32

 EFFICIENT SET OF PORTFOLIOS

PORTFOLIO NO. EXPECTED RETURN(%) STANDARD DEVIATION

1 5.6 4.5
2 7.8 5.8
3 9.2 7.6
4 10.5 8.1
5 11.7 8.1
6 12.4 9.3
7 13.5 9.5
8 13.5 11.3
9 15.7 12.7
10 16.8 12.9

03/19/10 BY: PROF. [Link] 33

 SHARE VALUATION MODEL

The valuation model used to estimate the intrinsic value of a

Share is the present value model. The intrinsic value of a
Share is the present value of all future amounts to be
received
In respect of the ownership of that share, computed at an
Appropriate discount rate.
The major receipts that come from the ownership of a share
Are the annual dividends and the sale proceeds of the share
At the end of the holding period.
These are to be discounted to find their present value at an
Appropriate rate.

03/19/10 BY: PROF. [Link] 34

 SAPM—CLASS TEST – TOTAL MARKS--20

[Link].1 : A share is currently selling for Rs.65/-. The company is expected to

Pay a dividend of Rs. 2.50 on the share at the end of the year. It is reliably
Estimated that the share will sell for Rs.78/- at the end of the year.

A. Assuming that the dividend and prices forecasts are accurate, would you
buy the share to hold it for one year, if your required rate of return were
12% ?

B. Given the current price of Rs.65/- and the expected dividend of Rs.2.50,
what would the price have to be at the end of one year to justify
purchase of the share today, if your required rate of return were 15% ?

[Link].2 : What is YIELD TO MATURITY ? How is it calculated ?

03/19/10 BY: PROF. [Link] 35